NEW YORK ( TheStreet ) -- Holding more than $500 billion in assets, target-date funds rank among the most popular choices in retirement plans. The funds are designed to serve people who will retire on certain dates, such as 2020 or 2035.
But some financial planners argue that the target funds are not perfect solutions. Critics contend that the one-size-fits-all portfolios should be tweaked to lower risks or to boost returns. "The strategies of target-date funds do not make sense," says Ron Surz, president of Target Date Solutions, which seeks to lower risks of portfolios.
At a time when most observers praise the target-date funds, the critics remain a distinct minority. Still, their views are worth considering because they suggest ways that retirement portfolios could be improved or customized by do-it-yourself investors.
The target-date approach has attracted millions of investors by offering balanced portfolios of stocks and bonds. For 401(k) participants, the diversified funds represent a step forward from the days when many savers put all their money in cash or the stock of their employers. Much of the criticism focuses on the asset allocations.
Funds for people in their 20s and 30s typically have 70% to 90% of assets in equities and the rest in fixed income. As savers age, the equity allocations gradually decline according to schedules known as glide paths. Portfolios for retirees have from 20% to 50% in equities. The thinking is that older people must be more conservative because they have little time to recover from market downturns.
Critics charge that the glide paths should be changed. Surz says that the funds for older people are hazardous because the equity allocations are too big. He points to the losses that equity portfolios recorded in the financial crisis. During the downturn of 2008, funds with target dates of 2000 to 2010 declined an average of 22.5%, according to Morningstar. For retirees, such losses could be devastating.
To avoid being caught in a downturn, Surz says that investors should begin shifting to cash 10 years before the retirement date. At the time of retirement, the funds should be entirely in cash. That way savers won't suffer big losses just before withdrawals start.
As they move into retirement, investors should seek customized solutions, Surz says. People of moderate means may decide to hold mostly annuities that provide guaranteed annual income.
Rob Arnott, chief executive of Research Affiliates, says that glide paths should be scrapped. Instead of gradually shifting allocations, investors would be better served by always holding half the assets in bonds and half in stocks.
To demonstrate the impact of allocations, Arnott looked at a hypothetical employee who saved $1,000 annually for 41 years. The saver followed a standard glide path, starting with an 80% equity allocation and tapering to 20% on retirement. Another saver in the study held 50% in stocks and 50% in bonds throughout the period.
Arnott examined the outcome over many different 41-year periods from 1871 through 2011. On average, the standard glide path produced a nest egg of $124,000, about $13,000 less than the 50-50 portfolio. The glide path was also more erratic, lagging badly during many periods when stocks fared poorly.
Arnott says that the problem with the glide path is that the portfolio is stock-heavy during the earlier years when the nest egg is small. Big gains from a small asset base don't add many dollars to the final portfolio.
To improve results and manage risks, Arnott proposes using a 50-50 portfolio and adjusting it with several tweaks. To lower risk for retirees, he suggests gradually reducing the maturities of bonds. During the first 20 years, the bond portfolio would focus on securities with 20-year maturities. Those tend to have higher yields and stronger long-term returns than shorter bonds do.
But the long bonds can be volatile, suffering losses when interest rates rise. To limit the hazard, Arnott suggests gradually reducing maturities during the 20 years before retirement. On the retirement date, the fixed-income allocation would be in Treasury bills, which could hold their value in a bond bear market.
So far, Arnott has won few followers. But some funds have moved in his direction recently, shortening bond maturities or increasing equity allocations for retirees.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.